So a 16 kilometer obstacle course through the mud, in the rain, at just above freezing sounded like a good idea. Until I got medic’ed out at kilometer 12 with hypothermia.
A lot of you will know that I was really looking forward to Tough Mudder in Badlands of Drumheller this year. And now I am here to tell you that I did not finish. I failed to complete the course. Failed to receive my orange headband. Failed my team.
I’m proud of what I accomplished and don’t mind sharing with you that I didn’t make it. Because I believe that failure is not an option. It’s a privilege reserved exclusively for those who try. I failed the course, but I’m proud of it. I am a better me for trying. I am more aware of my limits, very keenly aware of my body’s ability to retain heat, and impressed with my resilience and my strength. I pushed through, I didn’t whine, and I threw in the towel before I hurt myself, or anyone else. It was just enough.
It can be hard to know your limits if you’ve never been pushed to them before; hard to define what point is too much when you normally try to avoid situations that cause discomfort. Advisors are notoriously bad for judging an investors’ risk tolerance – we project our own beliefs onto others – and investors themselves tend to adjust their risk stated tolerance based on their most recent successes or failures.
So if I don’t know your limits, and if you take a dynamic view of them, what can we do?
The answer is to create a dynamic risk range that your portfolio can operate within. No, I don’t know your limits, but I do know the math. And with a bit of analysis, I can tell you what target risk level is appropriate for your goals. This is the first layer.
The second layer we look at is the range in which you are most likely to be comfortable. Where have you been comfortable in the past during a bull market? What about during a recession? We need to understand both. Long term goals are great, but if you aren’t able to stomach the ups and downs of the short term, you’ll never make it to the long term.
And the third layer to look at is what you’ve already got going on. If you figure you’re a balanced investor but all you’ve ever owned before is GICs, then we need to have a conversation. You know you can run at least 10K, but you’ve never been cold, wet, and muddy for six hours straight before? That’s okay. You can build your success in stages. You may fail at obtaining all of your upside potential initially, but you’ve still completed most of the course, and you didn’t die. The very last thing we want to do is shock-and-awe you into losing your ambition to save and your confidence in investing.
Once the three layers of your risk tolerance are compiled, we can establish the basic components of your investment strategy. This comes in two forms – addressing upside potential with your Strategic Asset Allocation, and addressing your downside potential through your Value at Risk.
Your Strategic Asset Allocation is the core of your investment strategy, and it reflects the most basic level of equities required for you to meet your goals. And it’s dynamic enough to reflect your changing perception of risk.
Imagine a ruler stick taped perpendicularly to a metronome shaft. The length of the ruler is the risk level you’re comfortable at, and the metronome is free to swing at its widest angle. If your ruler stick is short (low risk tolerance), and if it’s been taped to the top where the swing is the widest (representing a high level of equities), then there will be a gap between the front edge of your ruler during the farthest left swing and the back of your ruler during the farthest right swing. In this case, you need to set your Strategic Asset Allocation further down along the pendulum shaft (reducing equities) until the swing gap is closed.
That’s basically what a strategic asset allocation does. It uses your ruler length to guide your latitude so there is never a gap in your tolerance. Once established, we rebalance your portfolio along the ruler to keep your center of gravity as close to the core of the metronome as possible.
The metronome analogy helps to understand why a Strategic Asset Allocation is a measure of your upside potential. The higher up you are on the metronome shaft, the further your possible reach. The lower you are on the metronome shaft, the more confined your possible reach.
Upside is great, and your Strategic Asset Allocation needs to be monitored. But if you can’t make it through the downside, then your upside potential will be meaningless. Enter Value At Risk – a measure of portfolio downside protection.
Your Value at Risk is a measure of the worst theoretical loss your portfolio might experience during a severe global recession. Your metronome may be ticking along at the perfect speed, but what happens when somebody bumps the piano? We know it will get bumped. We’re just not sure when that will be, or how hard. And if your metronome starts to teeter while it’s still ticking (especially with the weight of your ruler taped to it), it won’t take much for it to crash to the floor.
To calculate Value at Risk we separate your portfolio into tactical, growth, stability, defensive, and GIC investments. Each section is shock tested and weighted to calculate your potential downside given a good hard shove. Anything less than 20% (half that for income portfolios), and your metronome stays upright. Anything more than 20% (or more than your established Value at Risk), and you could be into trouble.
You can keep your metronome planted firmly on the piano by making sure there’s enough weight in the base with GICs and defensive funds. We need some weight at the top too, for structural support, but with a solid enough foundation, you can be confident in leaving your portfolio ticking away during all kinds of market conditions and not having to worry about it crashing onto the floor.
If you’re keenly aware of your tolerance for risk, your Strategic Asset Allocation and your Value at Risk will help to guide your portfolio to success. If you’re still discovering your limits, then don’t be afraid to fail a bit the first round. If you plan for a 75% win, you’ll live to run again.
If you have questions on how to establish a goals-based investment portfolio, or for more information on how to work your way into a successful investment strategy, speak with a Certified Financial Planner today.
Written by Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER®
Advantage Insurance & Investment Advisors
Investment Funds Representative
Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.